472 PART 3 Market structure and Competitive strategy
output will be in equilibrium—or whether there will even be an equilibrium?
In §8.7, we explain that in a
competitive market, long-
run equilibrium occurs when
no firm has an incentive to
enter or exit because firms
are earning zero economic
profit and the quantity
demanded is equal to the
quantity supplied.
Nash equilibrium set of
strategies or actions in which each
firm does the best it can given its
competitors’ actions.
duopoly Market in which two
firms compete with each other.
Recall from §8.8 that when
firms produce homogeneous
or identical goods, consum-
ers consider only price when
making their purchasing
decisions.
Cournot model oligopoly
model in which firms produce a
homogeneous good, each firm
treats the output of its competitors
as fixed, and all firms decide
simultaneously how much to
produce.
To answer these questions, we need an underlying principle to describe an
equilibrium when firms make decisions that explicitly take each other’s behav-
ior into account.
Remember how we described an equilibrium in competitive and monopo-
listic markets: When a market is in equilibrium, firms are doing the best they can
and have no reason to change their price or output. Thus a competitive market is in
equilibrium when the quantity supplied equals the quantity demanded: Each
firm is doing the best it can—it is selling all that it produces and is maximiz-
ing its profit. Likewise, a monopolist is in equilibrium when marginal revenue
equals marginal cost because it, too, is doing the best it can and is maximizing
its profit.
nAsh equilibriuM With some modification, we can apply this same princi-
ple to an oligopolistic market. Now, however, each firm will want to do the best
it can given what its competitors are doing. And what should the firm assume that
its competitors are doing? Because the firm will do the best it can given what its
competitors are doing, it is natural to assume that these competitors will do the best
they can given what that firm is doing. Each firm, then, takes its competitors into
account, and assumes that its competitors are doing likewise.
This may seem a bit abstract at first, but it is logical, and as we will see, it
gives us a basis for determining an equilibrium in an oligopolistic market. The
concept was first explained clearly by the mathematician John Nash in 1951, so
we call the equilibrium it describes a Nash equilibrium. It is an important con-
cept that we will use repeatedly:
Nash Equilibrium: Each firm is doing the best it can given what its competitors
are doing.
We discuss this equilibrium concept in more detail in Chapter 13, where we
show how it can be applied to a broad range of strategic problems. In this chap-
ter, we will apply it to the analysis of oligopolistic markets.
To keep things as uncomplicated as possible, this chapter will focus largely
on markets in which two firms are competing with each other. We call such a
market a duopoly. Thus each firm has just one competitor to take into account
in making its decisions. Although we focus on duopolies, our basic results will
also apply to markets with more than two firms.
The Cournot Model
We will begin with a simple model of duopoly first introduced by the French
economist Augustin Cournot in 1838. Suppose the firms produce a homoge-
neous good and know the market demand curve. Each firm must decide how much
to produce, and the two firms make their decisions at the same time. When making its
production decision, each firm takes its competitor into account. It knows that
its competitor is also deciding how much to produce, and the market price will
depend on the total output of both firms.
The essence of the Cournot model is that each firm treats the output level of
its competitor as fixed when deciding how much to produce. To see how this works,
let’s consider the output decision of Firm 1. Suppose Firm 1 thinks that Firm 2
will produce nothing. In that case, Firm 1’s demand curve is the market de-
mand curve. In Figure 12.3 this is shown as D1(0), which means the demand
curve for Firm 1, assuming Firm 2 produces zero. Figure 12.3 also shows the